Looking at the Middle Income Trap in Latin America
Updated: Dec 29, 2022
I. Slow Growth & Little Progress
Unlike its Asian and European counterparts, many countries within Latin America have failed to graduate into higher-income status over the past years, making the majority of the Latin American region become stuck at the Middle Income Level. (Figure 1.1, 1.2, GNI Per Capita of Latin American Nations using Atlas method, based on World Bank Data, 2021) To examine why this is, the following column will look at factors such as; corruption, investment, and Latin America's abundance of scarce commodities. Then, the case of Chile will be examined to understand why countries can graduate out of the Middle Income Trap and what policy recommendations can be extrapolated to other Latin American nations.
Data for Income Classifications have been extrapolated before 1987.
Latin American countries have historically displayed low TFP growth. (Figure 2, TFP Growth in Latin America and the US for Comparison, based on data from The Conference Board)
However, unlike other economies, such as the Asian Tigers, who saw success through trade liberalisation paired with heavy investment into education and infrastructure, a strategy that promoted the development of higher value-added sectors, Latin America seems to not have the capacity to carry out a similar strategy of just investing into these sectors as the region's current hurdles are inhibiting TFP Growth - all of which are described below.
II. A politician's Playground
The institutions governing these nations are the main hurdle within Latin America that is stifling TFP growth and keeping the region locked within the Middle Income Level. Latin America has historically ranked poorly on the perceived corruption index. (Figure 3, Perceived Corruption within Latin America, 2020)
The detrimental Level refers to the boundary at which corruption is detrimental to growth. Countries below this boundary see their economic growth affected by corruption.
This means that governments within nations like Venezuela, Haiti, and Nicaragua, which are the lowest-ranked in the index, (Figure 3) are less likely to respect contracts from businesses that wish to invest in the region compared to nations like Chile (Figure 3). Consequently, this disregard for respecting contracts increases the chances of expropriation, as evidenced by Credendo’s country risk assessment. (Figure 4, Database Country Risks Synthesising Chart, Credendo 2021, Including the United Kingdom and the United States for comparison)
If this is done, or if any other action by a public body that violates a contract is committed, then the risks associated with investing in Latin America is significant. The chance of expropriation of profit and capital simply reduces the incentives for firms. Economies such as Venezuela that have to pay back expropriated assets come to mind when thinking about this issue. Yet, the problem of politics does not stop there. Not only does Latin America suffer from expropriation risk, but, it also houses generally unfriendly business practices. For instance, Peru heavily punishes businesses that employ more workers - disincentivising any business investment and capacities for economies of scale. This paired with high bureaucracy in Latin America, especially in Brazil where it takes an average of 152 days to register a business in Brazil compared to a world average of 48 makes doing business within Latin America difficult. Hence, this inefficient bureaucracy, anti-business policies and high corruption make the nations within the region un-friendly for businesses, resulting in Latin America being second to last in FDI rankings. This lag in FDI rankings has made Latin America fall behind internationally as the economy is seeing lower growth relative to its global counterparts. This is because FDI brings business investment, which, with it, brings innovation. The key ingredient for TFP Growth. For instance, when firms such as Tesla invest in countries such as China, they usually bring their technologies as well as expertise with them, meaning that high rates of investment from foreign sources can lead to specialised zones developing within a country, such as Siemens and GRI setting up in the UK to specialise in green tech production. Therefore, a country with low rates of FDI will see a lower technological growth rate than competitors as it takes longer for foreign technologies to enter the country and for specialisation to develop. This is a problem for Latin America. Weak investment prevents specialisation which hinders innovation both in product markets and in the development of products. As such, any slowdown in such innovation yields a reduction in TFP growth. So, because nations within Latin America are not advancing as fast compared to their counterparts, such as the Asian Tigers, who saw success as higher rates of FDI promoted the creation of high-value-added, technology-based industries, Latin America is becoming more competitively disadvantaged on a global scale as these countries are not developing a comparative advantage over a certain sector. This failure to move up value chains and to increase productivity through innovation is one of the factors keeping the nation locked at the Middle-Income level.
III. How Institutions Fail Their People
Furthermore, the institutions governing Latin America cause more issues for TFP growth and FDI rates as the institutions themselves are unable to protect the people. Countries within Latin America have higher homicide rates compared to the rest of the world, and, because of this, many individuals living within Latin America do not have faith in their political institutions. This combined with the lack of effective social welfare means Latin America has a large number of individuals living in poverty, a problem that has been exacerbated by the COVID-19 Pandemic. So, the question is, why should an individual, who is barely making ends meet, participate in the system? Well, the thing is that they don’t. Latin America has a very high rate of employment within the informal economy, with Peru being at 70%, and, at the same time, although primary education enrollment is somewhat decent, secondary and tertiary enrollment plummets. This decrease in enrollment for further education is likely attributed to the fact that the average young Latin American will find themselves more likely to get a job within the informal sector to support their family rather than embark on education. Therefore, the opportunity cost of spending time at school may not be worth it for the individual as they have to rationalise the fact that the lack of social welfare means they have to start generating an income for their family as soon as possible to survive. Unfortunately, this incompetence of the Latin American governments to provide welfare and protection for their people is decreasing school enrollment rates, which is significant as education plays an important factor in the rate of Foreign Direct Investment. Foreign firms are more likely to invest in a nation where the labour force is skilled. More importantly, firms that operate in high-value-added industries, such as green technology, automobile production or software development, require a labour force that has the skill sets necessary to operate within such industries. Consequently, Latin America, a region that lacks a sufficient amount of high-quality human capital due to low education enrollment, will inevitably fall behind compared to other nations, such as the Asian Tigers, who have seen success as their growing skilled labour forces are enabling for high-value-added industries, such as ones in semiconductors to prop up in countries like Taiwan. Therefore, the lack of developments within the Latin American labour market is inhibiting Foreign Direct Investment as there are simply more attractive countries for foreign businesses to go to.
IV. Political Polarisation
Another reason why the institutions governing Latin America are keeping the region stuck in the middle-income level is due to political instability. Latin American history is filled with dictatorships and oppressive regimes such as in Brazil and Chile, yet this long history still has its effects today as Latin America is ranked as one of the more politically polarised regions compared to the west according to the World Values Survey. This political instability creates additional problems as a politically polarised country will likely breed extreme governments, such as the one in Peru which has recently sworn in a Marxist for Prime Minister. This means that, because of these radically opposing views between parties, continuity in the form of an overall plan for the future is non-existence. In other words, every election or change in power can lead to progress being either reversed or wiped out. So, rather than there being a continuity between party policies, such as in developed countries like the UK, where despite who is in power, be that labour or conservatives, there is still continuity as it is likely that both parties will still move towards specific goals such as becoming carbon neutral by 2050, and building HS2. Therefore, this lack of a common goal between parties in Latin America is making infrastructure planning extremely difficult as it is almost impossible to plan a large infrastructure project since its progress may be halted if a new party comes into power. This combined with the regimes themselves being oppressive and corrupt makes infrastructure spending low. Therefore, due to the low rates of infrastructure spending within Latin America, the majority of the Latin American population suffers from poor-quality internet, telecommunications or even roads. This harms the geographical mobility of labour as low-quality infrastructure means travelling, or working from home is made more difficult. Hence, if individuals within these countries are unable to travel or access work from far away regions, such as the northern region of Baja California, which is developing higher-skilled, value-added industries in the automotive sector, then firms in these industries have a lower supply of skilled labour to access. However, The problems for firms are not just limited to labour. Other inputs such as raw materials will be more difficult to 'import,' and, firms will also find it more difficult to 'export' their outputs from local regions. Hence, low-quality infrastructure makes it harder for firms to access their inputs and can also make firms find it more difficult to export their outputs. As such, all of these costs such as longer travel times when it comes to importing and exporting goods and services continue to compound which makes Latin America quite unattractive for foreign investment.
V. The Miracle of Chile: Improving Institutions
However, it is not at all impossible for Latin America to begin improving so it seems like the most logical step for the region to take is to improve the stability, credibility and equality of its institutions. Although nations within Latin America, such as spectacular failures like Venezuela, or maybe even Peru with the recent announcement regarding the Marxist Prime Minister, may give the region a bad reputation, certain nations are much more developed. An example of one of these more developed nations is Chile, which, compared to the rest of Latin America, is ranked as a high-income country. (Figure 1.2) The nation also sees a higher ranking in the Human Development Index, 43 which places Chile higher than Argentina and makes it comparable to nations such as Croatia and Qatar. At the same time, Chile has more credible and stable institutions, which, due to their low perception of corruption, (Figure 3) help the nation benefit from a higher ranking of competitiveness due to the nation's economic freedom. Nevertheless, although Chile is now a liberalised economy with stable institutions, just like the majority of Latin America, the nation used to be ruled by oppressive oligarchic regimes up to General Pinochet, who, although was a dictator, paved the way for Chile’s success with the help of the Chicago boys. Under their supervision, the Chilean economy expanded at an unprecedented level, from growth rates of 3.5% in 1975 to 6.7% by 1990. During these reforms, HDI within Chile has increased from 0.64 to 0.84, meanwhile, its neighbouring country, Venezuela, has seen HDI increase at a rate less than half of that in Chile. At the same time, in 1980, Chile’s average income was less than half of that of Argentina, yet by 2008, they are now slightly higher as since 1975 Chile’s GDP per capita has quadrupled compared to Venezuela’s GDP per capita regressing by more than half. Chile’s success is not an accident, it is a perfect case study to show how economic liberalisation paired with the introduction of more democratic institutions that respect freedoms paves way for economic development. Fortunately, nations within Latin America are learning and changing, for example, in 2007, the OECD-Latin America and Caribbean Anti-Corruption Initiative was established where 7 Latin American and Caribbean nations, including Chile, have cooperated with the OECD to reduce bribery, in 2014, the operation car wash was introduced in Brazil, which resulted in former Brazilian President Lula da Silva seeing 12 years in prison after being found guilty of five corruption based charges, and, Ecuador’s new president has sworn the implementation of free-market policies. So, Latin American nations are making efforts to reduce corruption, albeit slowly as evidenced by the perceived corruption index. (Figure 3) Nevertheless, progress is being made, but is it enough?
VI. Policy Proposal
For countries part of the OECD-Latin America and Caribbean Anti-Corruption Initiative, further and faster action needs to take place for corruption to be reduced, and for the institutions to stabilise. This is because, for some of the nations within this said initiative, their perceived corruption ranking places them at the level at which their high corruption levels are detrimental to economic development (Figure 3) and why incompetent institutions hurt development is an area we have explored previously. This means that, through further cooperation with organisations such as the OECD, and maybe even the IMF, Latin America will be able to reduce corruption and begin to establish institutions. Through, IMF-backed funding the region can begin to increase spending on public goods such as infrastructure, education, and healthcare, all of which are instrumental for economic development. Additionally, Latin America's upcoming Fintech industry would see great support and development should it receive microfinance from these institutions.
Yet, this strategy will still prove difficult as many Latin American countries such as Cuba have poor relations with the US, and, at the same time, due to the political polarization within countries in Latin America, it will be challenging for a stable government, especially in a country like Venezuela, to prop up as the economic instability makes this very difficult without the assistance of a third party or foreign government such as the case of the Chicago Boys. So, it would be logical to conclude that for nations within Latin America, that have more anti-corrupt, stable governments and economic systems, such as Chile, Uruguay and Costa Rica, (Figure 3) it is essential for anti-corruption measures to continue as previously mentioned costs of corruption inhibit economic development and lead to a nation becoming trapped at the middle-income level. Meanwhile, for nations such as Venezuela, more radical reforms may be necessary to first stabilise the economy and then improve the quality of the institutions, in the hopes that doing so improves TFP and brings these respective countries out of the middle-income trap.